LIFO Liquidation:
(An Issue Related to LIFO Inventory Valuation Method):

Learning objectives of this article:

1. Define and explain the term "LIFO Liquidation".

Definition of LIFO Liquidation:

The erosion of the LIFO inventory is referred to as LIFO liquidation. Erosion means the unavailability or shortage of raw materials or other inputs that enforces companies to use its existing assets. LIFO liquidation leads to distortion of net income and substantial tax payments.

Example:

To understand the LIFO liquidation problem assume that XYZ company has 30,000 ponds of steel in its inventory on December 31, 2004. Costed on a traditional LIFO approach.

The ending 2004 inventory comprises costs from past periods. These costs are called layers (increase from period to period). The first layer is identified as the base layer. The layers for XYZ are shown below:

The price of steel has increased over the 4 year period. In 2005, the company experienced a metal shortages and had to liquidate much of its inventory (a LIFO liquidation). At the end of 2005, only 6,000 ponds of steel remained in inventory. Because the company is using LIFO, the most recent layer, 2004, is liquidated first, followed by the 2003 layer and so on.

As a result the costs from preceding periods are matched against sales revenues reported in current dollars. This leads to a distortion in net income and a substantial tax bill in the current period. These effects are shown below:

To alleviate the LIFO liquidation problems and to simplify the accounting, goods can be combined into pools. A pool is defined as a group of items of a similar nature. Thus, instead of only identical units, a number of similar units or products are combined and accounted for together. This method is referred to as the specific goods pooled LIFO approach. With the specific goods pooled LIFO approach, LIFO liquidations are less likely to happen because the reduction of one quantity in the pool may be offset by an increase in another.

The specific goods pooled LIFO approach eliminates some of the disadvantages of the specific goods (traditional) accounting for LIFO inventories. This pooled approach, using quantities as its measurement basis, however, creates other problems.

First most companies are continually changing the mix of their products, materials, and production methods. A business once engaged in manufacturing train locomotives may now be involved in the automobiler or aircraft business. A business that had used cotton fabric in its clothing now uses synthetic fabric (dacron, nylon, etc.). If a pooled approach using quantities is employed, such changes mean that the pools must be continually redefined. This can be time consuming and costly.

Second, even when such an approach is practical, an erosion (LIFO liquidation) of the layers often results, and much of the LIFO costing benefit is lost. An erosion of the layers results because specific good or material in the pool may be replaced by another good or material either temporarily or permanently. This replacement may occur for competitive reasons or simply because a shortage of a certain material exists. Whatever the reason, the new item may not be similar enough to be treated as part of the old pool. Therefore any inflationary profit deferred on the old goods may have to be recognized as the old goods are replaced.

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